Investors shouldn’t fret about the yield rise

Commentary: 10-year yield still has room to run

NEW YORK (MarketWatch) — Wall Street investors shouldn’t worry so much about the 10-year Treasury yield rising to nine-month highs.

Instead, they should embrace it as validation of what has been lifting stocks for the last several months: the belief that the economy is transitioning into a self-sustainable expansion.

Economic theory suggests rising Treasury yields are bad for stocks. They raise borrowing costs, which in turn crimps capital spending, hiring and home buying. In the real world, however, that doesn’t happen until the economic expansion is mature and yields are much higher. When the economy is still in the adolescent stages, like it is now, yields and stocks tend to move in the same direction.

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Fed Chairman Ben Bernanke faces U.S. House members publicly for the first time since Republicans took control. Video courtesy of Fox Business Network.

The yield on the benchmark 10-year Treasury note closed at 3.729% Tuesday, and has climbed 111 basis points since the end of October. Meanwhile, the S&P 500 Index
SPX, +0.59%
closed Tuesday at a 2-1/2-year high and has climbed 12% since October.

The 10-year yield still has a lot more room to run. Until last Friday, the yield had been stuck in a narrow range of 3.25% to 3.565% for two months. Since that consolidation followed a sharp 0.95-point spike in just six weeks, technicians view the recent breakout as the confirmation of a “flag continuation pattern.” A measured-move target for the breakout — the height of the pattern added to the breakout point — is around 4.5%.

Investors shouldn’t fret too much even if that ambitious target is reached. LPL Financial chief market strategist Jeff Kleintop said stocks and bond yields historically have moved in the same direction when the 10-year yield was below 5%, as measured by a 52-week rolling correlation above zero. By the same measure, it wasn’t until the yield was above 5% that stocks and yields moved in the opposite direction.

That’s not to say the yield’s rapid rise can’t cause stocks to stagger. But that’s not likely to happen for a while, and it probably won’t hurt stocks very much or for very long.

At the beginning of the last economic recovery, the 10-year yield spiked from a low of 3.074% in June 2003 to a then 11-month high of 4.668% just two months later. Stocks eventually started pulling back, but not until March 2004. The S&P 500 lost a total of 8.6% in the five months following its March 2004 high, which isn’t enough to constitute an official correction.

High Frequency Economics chief U.S economist Ian Shepherdson said recently that given what he sees as a normal lag in normal cycles, he doesn’t think the rise in yields off the October lows will impact economic growth until the end of the year. Based on the Wall Street rule of thumb that the stock market moves three to six months ahead of the economy, the rise in yields wouldn’t start hurting stocks until June at the earliest.

Perfect timing, because that’s when the Federal Reserve’s current Treasury buying program is scheduled to end.

Basically, if stocks start pulling back in the near term, investors shouldn’t blame rising yields. In the current market environment, what investors should worry about more is if the economy falters to the point that yields start falling again.

Tomi Kilgore writes Taking Stock, a column featuring insightful analysis of equity-related topics around the world. This column originally appeared on Dow Jones Newswires.

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